ESOP Policy

Employee Stock Ownership Plan (ESOP)

ESOP is a program that provides employees with the opportunity to own shares in
the company they work for. It is a form of employee benefit plan that gives workers
ownership interest in the company, aligning their interests with the success of the
business.
For example –
Company X has 10,000 shares, which are currently wholly owned by founders A and
B, giving them 100% ownership. They are looking to onboard an investor who is
willing to invest for a 20% stake in the company. Additionally, the investor requires
the establishment of an Employee Stock Ownership Plan (ESOP) that will allocate
10% of the company’s shares from the founders’ stake.
For example -
1. Initial Cap Table (100% Founders Ownership):
 Founders: 10,000 shares
Ownership: 100%
At the start, the company has 10,000 shares, all owned by the founders. There are
no investors or ESOP at this stage, so the founders collectively own 100% of the
company.

2. Cap Table After Investment (without ESOP):

 Founders: 10,000 shares
Ownership: 80%
 Investor: 2,500 shares
Ownership: 20%
Here, an investor joins and is allocated 2,500 shares, diluting the founders'
ownership. The total number of shares in the company becomes:
 Founders' shares: 10,000
 Investor's shares: 2,500
 Total shares: 12,500
This means the founders' percentage of ownership decreases from 100% to 80%,
while the investor now owns 20% of the company.

3. Cap Table After Investment and Introduction of ESOP:

 Founders: 10,000 shares
Ownership: 70%
  Investor: 2,857 shares
Ownership: 20%
 ESOP: 1,428 shares
Ownership: 10%

In this scenario, both the investor and the ESOP are introduced, leading to further
dilution of the founders' ownership. The total shares now increase again to include
the ESOP, and the distribution is as follows:
 Founders' shares: 10,000
 Investor's shares: 2,857
 ESOP shares: 1,428
 Total shares: 14,285
 Founders' ownership: 70% (down from 80%)
 Investor's ownership: 20% (maintained)
 ESOP's ownership: 10%

Without ESOP: The investor owns 20%, and the founders' ownership reduces from
100% to 80%.
With ESOP: The founders' ownership further reduces to 70% to make room for the
ESOP, while the investor's ownership remains 20%. The ESOP is allocated 10% of
the company.
This example demonstrates how adding new shareholders (investors, ESOPs)
dilutes existing ownership percentages, although the number of shares each group
holds can remain constant.
Company Background
 Total Shares Outstanding: 14,285 shares (including ESOP pool)
 Founders’ Ownership: 70%
 Investor’s Ownership: 20%
 ESOP Pool: 1,428 shares (10% of total shares)
ESOP Allocation to Employees
Company X has hired four employees who will receive allocations from the ESOP
pool as follows:
 Employee A: 300 shares
 Employee B: 400 shares
 Employee C: 300 shares
 Employee D: 428 shares
Total Shares Allocated: 1,428 shares (fully utilizing the ESOP pool)
Vesting Schedule
Each employee's shares will vest over a four-year period. The allocations for the
first year are as follows:

Employee Total Shares Allocated Shares Vesting in Year 1

A 300 75

B 400 100

C 300 74

D 428 107

Tax Implications
Exercise Price and Tax Calculation:
 Face Value of Shares: The employees are required to pay tax on the
difference between the face value of the shares on the exercise date and the
exercise price at the time of exercising their options.
 Example Calculation:
o Face Value of Share: ₹100 (for simplicity; this can vary based on the
company's decision)
o Exercise Price: Assume an exercise price is set at ₹10 (as an
example).
Taxable Amount Calculation:
The taxable amount (perquisite) for each employee upon vesting can be calculated
as follows:
Taxable Amount = (Face Value on exercise date − Exercise Price) × Shares Vested
Important Terms
1. Notional ESOP Pool - A Notional ESOP Pool is a conceptual allocation of
shares or options that represent a value for employees without actual shares
being issued at the time. It is typically used for accounting purposes to
calculate potential employee benefits based on future equity value without
diluting current shareholders.

 Employees are granted notional units that represent a specific number of

shares or options.
 These units accrue value based on the company's performance, typically
tied to the increase in share price over a defined period.
 Unlike traditional ESOPs, employees do not receive actual shares but are
instead entitled to receive a cash payout or equivalent value upon certain
triggering events, like an exit or liquidity event.

2. Virtual ESOP Pool - A Virtual ESOP Pool operates similarly to a Notional

ESOP but typically focuses on the appreciation of the company's shares
without granting any actual shares. Employees receive virtual shares that
mirror the value of real shares.

 Employees receive virtual shares, which represent a right to receive a cash

payment based on the company's share price at a future date.
 These virtual shares may be linked to performance metrics or the
company's valuation and may vest over time, like traditional ESOPs.
 Employees do not hold any voting rights or ownership in the company, as
no real shares are issued.

3. Stock Appreciation Right (SAR) - Stock Appreciation Rights (SAR) are a

type of employee incentive that grants employees the right to receive the
appreciation in the value of a specified number of shares over a set period
without requiring them to purchase shares.

 Employees are granted SARs, which entitle them to receive the difference
between the stock's current market price and the grant price when exercised.
 Unlike stock options, SARs can be settled in cash or shares, depending on
the company’s policy.
 SARs can be awarded with or without an accompanying option to purchase
shares.
Best and Optimal way to deal with ESOP issuance
Creating an ESOP Trust: A Preferred Structure for Virtual ESOP Pools
Overview: To avoid the immediate issuance of shares to employees while still
providing them with a beneficial interest in the company's shares, many
organizations opt to establish an ESOP (Employee Stock Ownership Plan) trust
under Indian Trust Act,1882. This approach allows for flexibility in share ownership
while ensuring that employee interests are protected and aligned with the company's
growth.
Key Objectives of Establishing an ESOP Trust
1. Preservation of Share Capital:
o By creating a virtual ESOP pool managed through an ESOP trust,
companies can maintain control over their share capital.
o Employees do not have the right to sell ESOP shares directly, as those
rights are retained by the ESOP trust or the company’s management.
This prevents immediate dilution of shares and helps stabilize the
company’s equity structure.
2. Building Employee Confidence:
o An ESOP trust introduces confidence among employees that they will
receive the promised benefits. It serves as a commitment mechanism,
ensuring that employees' interests are aligned with the company’s
success.
o Employees are assured that the ESOP trust is dedicated to managing
and eventually distributing the benefits from the virtual ESOP pool.
Employee Benefits and Rights
 Beneficial Interest in Virtual ESOP Shares:
o Employees receive a beneficial interest in the virtual ESOP shares
without actual ownership of the shares until certain conditions are met.
o If employees leave the company, they retain the right to any vested
shares they exercised. Their beneficial interest continues even after
their employment ends.
 Non-Transferability of Beneficial Interest:
o The beneficial interest in the virtual ESOP shares is not transferable,
ensuring that the intended purpose of the ESOP trust remains intact.
o However, employees can appoint a nominee to act on their behalf
regarding their beneficial interest, providing a level of flexibility in
representation.
Role of the ESOP Trust
 Trustee Appointment:
o The trustee of the ESOP trust is an independent individual or entity
appointed by the company. This ensures impartial management of the
trust and the interests of the employees.
o The trustee is responsible for overseeing the administration of the
ESOP trust, managing the virtual ESOP pool, and ensuring compliance
with applicable regulations.
Case Study –
Tech Innovations Private Limited, a dynamic tech startup with 10,000 shares fully
owned by its founders, Aditi, and Bhavesh, sought a way to attract top talent without
diluting their equity too early. They established an ESOP (Employee Stock
Ownership Plan) Trust, creating a Notional ESOP Pool of 1,000 notional shares. This
innovative approach would provide employees with a stake in the company’s
success while safeguarding the founders’ ownership.
Situation: In the first year after implementing the ESOP Trust, Tech Innovations
hired four talented employees: A, B, C, and D. They were each granted notional units
that represented future cash payouts based on the company’s growth.
 Employee A (Software Engineer) received 400 shares.
 Employee B (Product Manager) received 400 shares.
 Employee C (UX Designer) received 200 shares.
 Employee D (Marketing Specialist) received 100 shares.
One year later, Employee A received an offer from a leading tech firm with an
attractive salary package and opportunities for career growth. While excited about
the new role, Employee A was also uncertain about leaving Tech Innovations and the
benefits of the notional units.
Understanding the Benefits of the ESOP Trust: Before making the decision,
Employee A consulted with the HR department, where they explained how the ESOP
Trust would continue to protect their interests even after leaving the company.
 Retention of Vested Interests: Employee A learned that they had accrued
100 shares (25% of their total allocation) during their year at the company. If
they chose to leave, they would still be entitled to receive a cash payout
based on the company’s growth at the time of a liquidity event, like a sale or
public offering.
 Non-Transferability and Nominee Option: The HR team reassured
Employee A that while their beneficial interest was non-transferable, they
could appoint a nominee to manage their interests in the trust. This meant that
their hard work would not go unrewarded; they could ensure their family
benefited from their contributions to the company.
The Outcome:
 A Successful Transition: Two years later, Tech Innovations Private Limited
successfully secured funding from a venture capital firm, leading to a
valuation increase from ₹10 crore to ₹25 crore. Employee A, now at their new
company, received a payout of ₹7,500 for their 75 shares based on the
appreciation in company value, proving their decision to stay connected with
the trust worthwhile.
 Preservation of Share Capital: By establishing the ESOP Trust, Aditi and
Bhavesh effectively preserved their share capital. Since no actual shares
were issued to employees, the founders retained control over their ownership
stake, which was crucial for future funding rounds. This preservation allowed
Tech Innovations to negotiate funding at a higher valuation without the
immediate dilution of equity, which could have been detrimental at the early
stage. The founders secured ₹15 crore in funding at a valuation of ₹25 crore,
giving them ample runway for growth while maintaining their strategic vision
for the company.
 Building Trust and Confidence: Aditi and Bhavesh observed that their
ESOP Trust not only retained valuable employees but also maintained a
positive workplace culture, even when some employees left. Their
commitment to managing the ESOP Trust transparently built trust within the
team, motivating employees to perform at their best, knowing their efforts
could still yield rewards.